Paulson's Fannie-Freddie fix
Investors fear the Treasury chief will maul shareholders, a la Bear Stearns. But he may be less heavy-handed this time.
NEW YORK (Fortune) -- The market is betting Henry Paulson is about to put on his black hat again. But the Treasury secretary may not be so easily typecast in the saga of the government-sponsored mortgage finance companies.
Shares in Fannie Mae and Freddie Mac hit new lows this week on speculation that the government will be forced to support the companies. With the shares down more than 90% over the past year, analysts such as Paul Miller at Friedman Billings Ramsey say the only way the companies can raise enough money to soothe the markets is to lean on the government.
"They're going to need some help here," says Miller, who has written that Fannie and Freddie need to raise $15 billion each to see them through the housing bust.
Fannie and Freddie are shareholder-owned, though they have been able to borrow at below-market rates thanks to an implicit government backing for their debt. Paulson said last month he wants to keep the companies, which buy and guarantee around half of all U.S. home mortgages, in their current form to help ease the pain of the housing bust.
But with investors fretting over possible changes in the companies' capital structure - while Paulson has essentially stood behind the companies' senior debt, he hasn't said what would happen in any restructuring to other securities - the companies' low-cost funding advantage has eroded, pushing mortgage rates up and adding to the pressure on house prices.
So Paulson may soon have to act. The big question is whether he'll reprise his villainous role in the Bear Stearns rescue. For now, there are reasons to think he might not.
When the brokerage firm collapsed in March, Bear and would-be buyer JPMorganChase (JPM, Fortune 500) were discussing a deal at $8 to $12 a share. But Paulson wanted Bear Stearns shareholders to get just $2 a share, to avoid the perception that taxpayer dollars were being used to bail out fat-cat Wall Street types.
Bear shareholders eventually got $10 a share, after the deal was renegotiated to calm Bear investors who were threatening to block the deal. Even so, the markets have taken Paulson's stance in the Bear bailout to mean any government support for Fannie and Freddie might render existing shares worthless.
"It seems a foregone conclusion that shareholders are going to be wiped out," says Paul Hickey at investment adviser Bespoke Investment Group in Harrison, N.Y. "But the stocks haven't gone to zero yet."
Indeed, while the outlook for shareholders is uncertain, to say the least, the problems at Fannie and Freddie aren't as dire as the ones that led to the collapse of Bear. That fact may allow Paulson to put away his cudgel.
The contrasts between Bear and the GSEs are easy to see. Bear essentially ran out of cash after its customers pulled their funds in a run on the bank. By contrast, even skeptics of Fannie and Freddie acknowledge they aren't about to go broke.
Fannie and Freddie were above their regulatory minimum capital requirements at the end of the second quarter - substantially so in Fannie's case - and both are able to borrow from the Fed in an emergency funding crisis, of which there has been no evidence in any case.
"Sober analysis shows they have enough capital," Fox Pitt Kelton analyst Howard Shapiro writes in an e-mail. Shapiro, who rates the stocks overweight, wrote in a report Tuesday that the companies' credit exposure looks "scary" at first glance but actually is likely to be quite manageable, given the quality of their loans and their substantial capital resources.
What's more, the Fannie-Freddie situation lacks the urgency of the Bear meltdown. The government pushed through the sale of Bear because officials feared the markets could unravel if the firm, with its massive derivatives book, failed. With the health of the capital markets at stake, Paulson and New York Fed President Timothy Geithner had to put a deal together, and fast.
In contrast, Fannie and Freddie don't look like a ticking time bomb. The uncertainty about the companies' fate is clearly weighing on the markets right now - Hickey notes that the spread between risk-free Treasury securities and the Merrill Lynch High-Yield Bond Index recently spiked to their widest levels since Bear collapsed. But since Paulson has the luxury of a bit of time to weigh his options, it's far from clear that Treasury's solution has to involve a shareholder wipeout.
None of this is to say that Paulson, who last month received authority from Congress to invest in Fannie and Freddie in case of a market emergency, won't have to take any action - or that the companies' shares are a clear bargain even at these reduced levels. "Why would you buy these?" asks FBR's Miller, who rates the stocks underperform thanks to the uncertainty surrounding coming credit losses and the associated capital situation.
Moreover, the Asian central banks that have long been big buyers of agency paper have slowed their purchases. If bond buyers show further reluctance, the companies' costs could rise more - a significant consideration with more than $200 billion in agency debt in need of refinancing in coming months.
That said, any solution that clarifies how investors in Fannie and Freddie's common and preferred stock and subordinated debt stand - without looking like a complete massacre - could be met with relief in the market. Miller says resolution of the uncertainty around Fannie and Freddie could send shares in other financial companies sharply higher, as people using the uncertainty to bet against bank and brokerage stocks might then cover their shorts, feeding "a massive short squeeze across the financials."